It's no credit to them

JOHN WOODS / WINNIPEG FREE PRESS Enlarge Image

Karen and Barry plan to buy a boat this spring. But using a TFSA to pay off their debt would be a better option.

Karen and Barry should be a financial power couple.

Recently married and in their early to mid-40s, they earn a combined six figures annually.

The problem is, they also have a mountain of debt.

"We were both in former relationships that cleaned us out," says Karen, who recently started work with the provincial government. "We started our married life together really in debt."

Karen earns about $63,000 a year, or about $3,340 in take-home pay a month.

Barry works in the private sector, earning about $52,000 a year and roughly $3,040 a month net.

They have about $86,000 in savings, mostly in RRSPs, with $5,800 in a TFSA that will be used to purchase a boat in the spring.

Their home is worth about $225,000, with $156,000 owing on the mortgage. They also have a Manitoba Hydro loan and car payments.

Barry and Karen owe more than $31,000 on one personal line of credit and seven credit cards. Most of them are at or near their limit. The lowest interest rate is 10.75 per cent and the highest is 24 per cent.

"We'd like to eliminate our debt and get a long-term picture of our financial future," Barry says. "I think we're moving in the right direction, but we want to tweak it to get the most out of our money."

Financial planner and adviser Doug Nelson says Barry and Karen may not be moving along as well as they think. What they really need is a measuring stick.

"We need to evaluate how well they are using their money, so that they can make the types of changes that they wish to make and reach the goals they want to achieve," he says.

A certified financial planner with Nelson Financial Consultants in Winnipeg, Nelson says a personal finance book called The Millionaire Next Door explores the financial habits of wealthy people and uses a simple equation that can measure how efficiently they're using their income.

"This will give them an idea of the target level of net worth they should have today, based on their income levels."

The formula is as follows: Age, multiplied by annual income, divided by 10.

Their average age is 43; total income is about $115,000 a year. Multiply those figures and you get $4,945,000. Divide that figure by 10 and their net worth today should be about $497,157.

Their actual net worth is $147,310.

"This would suggest that Barry and Karen are not using their financial resources as well as they could be at this time in their life," says Nelson, author of Master Your Retirement.

He says the couple will need to save more for retirement, and they also need a strategy to pay down their mortgage and their other debts faster than the present pace.

Based on their current retirement savings strategy -- excluding Karen's government pension plan, which she recently started -- they will have about $229,170 in assets in 20 years. That's based on a five per cent market return. If they were to withdraw five per cent a year in retirement, they'd earn about $11,458. With CPP, likely about $7,000 each a year, they'd gross about $25,000, which is far below the $115,000 they earn today.

And they'd still be paying off their mortgage. Barry and Karen have a 30-year amortization mortgage. This is costing them more than it should because they should have the ability to pay it down more quickly. Over 30 years, they'll pay about $76,000 in interest at the current rock-bottom rates. If rates rise to the historical average, seven per cent, they could pay as much as $214,500 in interest.

The rub is that Barry and Karen earn enough to double their mortgage payments and dramatically increase RRSP contributions, but their consumer debt is holding them back.

The average interest rate on their line-of-credit and credit-card debt is about 13 per cent, or about $4,260 in interest payments.

"To get their financial situation back in order, the first thing they should do is cut up all of their seven credit cards," Nelson says. "Based on their incomes, there should be no need to access credit."

Ideally, they would transfer high-interest debt to a line of credit against the house, which has a much lower rate.

"But this may not be possible for Barry and Karen," Nelson says. "Their primary asset, their home, is already at the upper limit, as the mortgage represents 70 per cent of the value of the home."

Most lenders are willing to go as high as 75 per cent of the value of the home.

"This is not a positive sign of good financial health," he says.

Fortunately, Nelson says the couple earns enough money to pay off debts quickly if they become more disciplined spenders. They spend more than $1,000 a month combined on discretionary items.

"It would appear that while they share a number of the household expenses, there does not seem to be any boundaries on personal spending," he says, adding they have separate accounts for personal costs.

Nelson says they should challenge themselves to contribute to their joint account an extra $2,000 a month, which could pay off the mortgage faster and build up savings.

"I would bet they could streamline their expenses enough that they could easily come up with this type of savings."

If they can increase monthly payments on the mortgage to $855 from $603, for example, they would reduce the amortization to 20 years.

With credit-card and line-of-credit payments, finding $2,000 extra might be too challenging, so they may want to focus on paying off those debts first.

They are currently paying $1,200 a month on credit cards and the credit line. At that pace, they will eliminate the debt in two-and-a-half years. Yet if they use their cards to add as little as $400 a month in expenses, it will take eight years to pay off the debt, with $8,000 going toward interest.

They could speed up the pace of repayment by using the TFSA -- about $5,800 -- to pay down some of the debt. Given their circumstances, it's a better use of their savings than purchasing a boat, Nelson says.

"Ironically, the amount of interest they pay in credit-card and line-of-credit debt could buy them a boat each and every year for life."

Controlling spending is obviously central to making the plan work, and it won't be easy, Nelson says.

If they can do it, they'll be free of credit debt very soon, They will be able to maximize RRSP contributions, and their mortgage will be paid in 20 years. At that point, their net worth should easily be more than $500,000, and they could then consider retiring comfortably, he says.

"All they need to do is focus on the details of where their money goes each and every month."

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Republished from the Winnipeg Free Press print edition January 14, 2012 B13